Not many investors are enthusiastic about bonds these days, and it’s hard to blame them. While rates have ticked up in the last few weeks, they’re still so low that even some sophisticated investors have abandoned them altogether. I’ve spoken to some investors who are ready to follow that advice, though they are not prepared to ride the roller coaster of a 100%-equity portfolio. So they’re asking whether they should just swap their bonds for cash.
At first blush, this looks like a good strategy. As of May 6, the yield to maturity on short-term bond ETFs is barely 1% after fees. Even broad-based bond ETFs (which have average maturities of about 10 years) have a yield to maturity well below 2% after accounting for management fees. Meanwhile, most investment savings accounts (ISAs) are paying at least 1%, and if you hunt around you can find high-interest savings products with much better yields: Equitable Bank offers one at 1.45%, while People’s Choice has a savings account at 1.60% and a TFSA savings account at 2.25%. Why take risk with a bond ETF when you can get a higher yield from cash, with no volatility and CDIC insurance to boot?
There are many situations where it does indeed make sense to use a high-interest savings account rather than a bond fund. Certainly if you are putting money aside for a short- to medium-term goal—like a down payment or other major purchase—cash is king. But if you’re a long-term investor with a diversified portfolio, a bond index fund is probably a better choice. Let’s look at why.
It’s not just about yield
Bond yields are dismal today, but let’s remember that you add bonds to a diversified portfolio not to boost your returns, but to dampen your overall volatility. Bonds funds can fluctuate in value, but they are nowhere near as volatile as equities, so they’re like adding cool water to a hot bath to make it more comfortable.
Adding cash to an equity portfolio will also lower the volatility, but not nearly as much. That’s because bonds tend to have negative correlation with equities during times of market turmoil. In other words, when stocks plummet and the economy is in recession, interest rates typically fall, which drives bond prices up. That boost can offset at least some of the losses you experience on the equity side of your portfolio.
You don’t have to go back very far to see some examples. In 2008, when the global stock market shed about a third of its value, broad-market bond index funds delivered over 6%. And during the turmoil of 2011, when Canadian and international stocks tanked, bonds returned well over 9%. That cushioned the blow and provided opportunities for rebalancing by selling some of those bonds and buying equities with the proceeds.
Holding cash in your portfolio during a stock market correction offers a much smaller benefit. Your savings account will never spike in value and offset losses on the equity side, and it’s likely to disappoint if a recession rears its head. When interest rates fall, savings accounts will just pay you less going forward.
It’s always important to consider asset classes in context, rather than in isolation. On their own, investment-grade bonds are unattractive today if your goal is simply to earn interest income in the short term. But if you’re in it for the long haul, never forget that bonds are still the asset class that puts the balance in a balanced portfolio.
I don’t understand the rate falling = negative corelation argument in the current environment. With a 1% yield, the rate really has nowhere to go from there. If a recession started tomorrow, where could bond prices go?
@Shane: Yields can go lower than 1%. With short-term bonds any bump from falling interest rates would be very modest (and the argument for cash is stronger). Broad-based bond funds currently yield closer to 2% and can fall further, and that can easily mean a price increase of several percentage points.
I believe we all understand that yields can still move lower but aren’t we very close to the floor, which implicitly means bond returns have a limited capability to diversify equity? It was mentioned in the article that 2008 and 2011 bond returns yielded 6% and 9%, respectively, but with yields this low could this happen again, with yields this low, if we were to enter another recession in this time of market highs?
A timely post, Dan. I wonder whether you would be willing to comment on an article, “Where to Invest $1,000,” in the latest MoneySense by David Hodges. His comments surprise me, actually, because in saving up for a wedding, car or home down payment he recommends eschewing savings accounts and GICs for a short-term bond index fund such as VSC. Personally, I would never make that recommendation.
“aren’t we very close to the floor?”
What floor? 0%? It will be interesting to see if bonds still do their job during the next crash if the rates are negative then. A lot of countries are already experimenting…
Do you know when your webinar will be on the Canadian MoneySaver site ?
@Fluffy There was an interesting article in the G&M a few months back addressing the question “why would anybody buy a bond with a negative interest rate?” when Switzerland instituted negative interest rates. One of the key answers was if you think you’ll lose less money with the negative bond than with all the other options.
There’s always a “flight to safety” when stock markets are crashing and bonds typically rise because of this. Mind you, with a negative rate bond there would also need to be a reason to avoid cash (hyperinflation?).
I’d say this falls into the ‘stay out of your own way’ – Don’t try to decide that ‘there’s no place for interest rates to go but up, so bonds will go down – I might as well be in cash’ – It’s attempting to predict the future and time the market. Leave your asset allocation alone – if you’re adding a ‘cash’ allocation within your fixed income, make sure you’re doing it for other reasons, not trying to time the bond market.
Just wondering why Hubert Financial seems to be missed. They currently are paying 1.9 percent. Been with them year and have been happy so far and they seem to have the one of the top returns.
5 year GIC on investorline today for 2.25%. I have about half of my fixed income in GIC’s and with such low yeild to maturities I’m leaning towards all gic’s.
Or just invest in the banks for dividends, it seem like their fees go up all the time and don’t lower their mutual fund fees and we as consumers are getting a low return. It’s not so bad when pay 1% for a bond fund when rates are high but paying the same now days as you did 10 years ago for such low rates it doesnt’ seem worth it.
I’m considering putting extra money toward a mortgage at 3% instead of buying bonds. Does that make any sense? Seems like a better use of money than a savings account.
Can you provide some evidence that bonds are negatively correlated with stocks… I don’t believe that is accurate. I’ve seen research from Pimco suggesting the historical beta if about 0.07 so close to zero but certainly not negative. If cash is zero and pays a higher rate it is superior in both regards. The benefit of massive bond investments for large cap players is a level of liquidity they can’t achieve with personal savings accounts but that’s no reason in itself to not trade for cash.
If you use bonds to balance your portfolio, consider this:
If the stock market has a big decline and bond yields do fall to zero (increasing bond values), and you want to rebalance your portfolio at that time, just who do you think that you will be selling those bonds to?
At that point, they will be paying little or no income, and have little or no prospect for capital gains. Who is the greater fool that you can sell them to?
There is a risk that the market will lose all liquidity, and become no-bid due to lack of buyers.
In my opinion, that day is coming. The bond market is in bubble territory, and there is a big risk of a bond market crash at some point if this central bank foolishness doesn’t end soon.
Cash does have a low correlation with equity though. And the Fed will raise the interest almost for sure, I do not think it is a bad idea to hold cash for now.
@Doug: Bonds may carry some liquidity risk, but let’s make sure your logic makes sense. If bond yields fall very low, it will not mean that existing bonds “will be paying little or no income.” On the contrary, they would become more valuable, since they will pay much higher coupons than newly issued bonds. How can an asset simultaneously rise in value and have a lack of buyers? It sounds like that joke: “No one goes to that restaurant anymore because it’s too crowded,”
@Luc: The decision to pay off debt versus buying bonds is very different from what I am discussing here. I think it’s almost always a good idea to pay off debt before investing, and it’s certainly a better idea than holding cash.
@Russ: I would have to say I disagree with that advice too. Any short term savings should be in a vehicle with no chance of loss.
@CCP:
As you say, the value (price) of the bond increases as the difference between the market interest rate widens to the downside from the bond’s coupon rate.
The question that I posed is whether there is a point where it doesn’t make sense to buy bonds or bond ETFs any more. That question is the entire point of your blog article….
If rates continue to go down, or are forced down by an equity market crash, the asking price for bonds will increase. The question is, will bonds be a good investment at that time, and will there be any buyers at that price? I doubt it.
Think about it from the buyers point of view. Why would you buy a premium-priced bond at a zero market interest rate? Although you would indeed get interest payments, you have paid for those payments by paying more than par value for the bond, and after all is said and done you will end up with nothing if rates stay the same. If rates normalize, you’ll lose money.
If a popular restaurant prices itself too high and is not of good value, people won’t go any more.
Doug,
If there aren’t buyers, then the price goes down or rates offered up until there are buyers. Basic on how the market works – if the yield goes so low a bank account pays more, the demand dries up, price down, yield up.
Thanks Dan for another great post. Are you sure you don’t want to pull your site into a book. So often topics and contexts roll in circles–I love the expression ‘Deja Vu all over again’. You are a rock star in your own domain and are certain to produce a best seller– and I promise to buy the book.
Always looking forward to the next scrum.
Why not E-series Japanese index for allocation rather than bonds/cash? Has outperformed Couch Potato suggested portfolio distribution for 2015.
@CraigM:
Thanks. That’s exactly my point.
If there is a point where bonds or bond ETFs don’t make sense to a buyer, the price will go down to where it does make sense for them, basic supply and demand. All I’m saying is that in such a scenario, bond ETFs may not provide the protection to couch potato portfolios the way that people think they might during a severe equity market decline. With rates so low, there cannot be a great deal of negative correlation room left, and it might be difficult to sell some of those bonds at a proper price to rebalance your portfolio when rates are even closer to zero.
I actually think that the next crisis will be in the bond market anyways, and the equity market will be dragged down with it, but that’s another story….
@Doug: I don’t mean to be disrespectful, but CraigM’s argument is the exact opposite of yours because your reasoning is precisely backward. I think it’s important for readers to understand this concept or they risk making poor investment decisions.
It’s simply not accurate to say that it might become difficult to sell bonds if rates move lower. The reasons rates fall is precisely because there are so many motivated buyers. Unlike in the restaurant analogy (where you suggested that a restaurant could set prices so high that customers would not eat there), bond prices and yields are the result of supply and demand. The bond issuer does not set the price. They set the coupon and the market sets the price.
If we do experience a prolonged bear market in bonds, which is certainly possible, it would be because rates move up, not down. Rising rates will cause the value of bonds to fall, and jittery bond investors will likely start selling their holdings, often in a panic. Lots of motivated sellers would mean prices would fall and yields would go up.
@TG: Please note that I said “bonds tend to have negative correlation with equities during times of market turmoil.” That’s not the same as saying they are negatively correlated with stocks during all periods. This is pretty uncontroversial. When people panic during stock market crashes they tend to sell stocks and buy bonds, pushing bond prices up.
@CPP:
I agree. In a normal market, interest rate yields and prices are set by supply and demand. However, it is far from a normal market, with the Fed’s QE in the US, and central banks in the EU and Japan (and now China) buying huge amounts of bonds with money that they create from thin air, and the bond market is completely distorted from the artificial demand. Many banks, pension funds, and insurance companies are forced to buy those government bonds by regulation or mandate, and those purchases affect other bond prices, such as corporate bond ETFs.
Hedge funds and other private buyers (like us), don’t need to follow suit, and I suggest that they won’t buy them if it doesn’t make sense to them. For example, in Switzerland and Germany, the bond rates are negative, so you are assured to lose money even if rates don’t change. If you leave money in the bank, they charge you interest. If rates rise (which they really must unless we get a prolonged period of deflation), you’ll lose a lot of money on those bonds. It is pure insanity. In those countries, you would be better off getting a draft or certified cheque from the bank and putting it into a safety deposit box to cash later and at least get your money back. Why would you buy a bond at zero or negative prevailing interest rates unless you really thought that the world was going to hell in a hand cart, and expected the rates to become even more negative?
Of course I don’t want to influence people to make poor investment decisions, but I personally believe that the downside risk of owning bonds in this environment is much greater than the stabilizing value that they can provide in a traditional balanced portfolio.
Intelligent investors , including you in this blog posting, are starting to question whether bonds still have a place in a balanced portfolio. That’s a good thing.
I’ve been a Couch Potato investor for many years, but I’ve recently moved most of my fixed income allocation into other things like GICs, with the intent to purchase bonds in my portfolio again in a few years at a lower price once (or if) rates normalize and at least cover taxes and inflation. I’m not suggesting that others do the same.
@CCP:
I re-read the first link in your post above from the Globe and Mail, (Who needs bonds), and find that my position is the same as that. The writer talks about the bond market stalling out because there is no reason to buy bonds, and the potential for people that think that they are holding safe assets to suffer significant losses.
I’m not sure that many of your readers appreciate this, but your recommended bond portfolio holding (Vanguard’s VAB) has an average duration of 7.8 years, so if the Fed starts raising rates like they have signaled, the value of the ETF will fall by that factor. A 2% rise in interest rates would cause the ETF to lose over 15%.
I think what Doug is saying is if the current bond yield is 1% and you are holding a 5 year bond ETF, and negative yields more than a few basis points are unsustainable, the best you can reasonably expect is a 5 percent capital gain if stocks go south. This appears to many to be a small return for the potential risk of rates rising. Of course GICs aren’t liquid and are not an equivalent product, but if you aren’t selling it doesn’t matter.
Thanks Rob, I guess that is what I am saying.
There isn’t much more room for rates to fall, and if they do you might make a small profit but bonds will be fully priced with no more upside, only downside. At that time, bonds would no longer provide any portfolio protection at all in a balanced portfolio, and millions of investors around the world will be looking for the exit.
My original comment was based on the question, who will be the buyers of fully valued securities with no upside?
As rightly pointed out by @CPP and @CraigM, supply and demand, or fear and greed, will set the price, but surely we all realize that not everybody will be able to get out at the top. The door isn’t big enough.
The sharks will be circling as they try. With any luck, I’ll be one of them.
Doug, if a bond has a negative yield, the market is pricing in deflation. Eg. If a bond has a yield of -0.1%, and inflation is -0.5%, the investor is making a real yield of 0.4%. The bond investor is still ahead even with a negative yield.
I think you are focusing too much on the return of bonds in isolation, and forgetting about the diversifying properties of bonds in a portfolio, which currently, in particular, is the main point of owning them. No matter what interest rates are, in times of stress a flight to safety occurs, pushing up bond prices giving you money to buy depreciated stocks.
Also, if interest rates rise, bond prices will fall, but only temporarily. Hang onto the bond fund for it’s duration and you’ll get your money back.
You could just use the 200 Day Moving Average as a buy/sell signal for BOTH your bonds and stocks and you would avoid big losses and sleep better at night.
Remember Warren Buffet’s first rule of investing: “Don’t lose money”
Using the 200 Day Moving Average as a buy/sell signal for all asset classes allows you an objective way to achieve the goal of minimizing the draw down on your portfolio.
This link has great graphs showing how you would miss the big draw downs of market crashes:
http://www.advisorperspectives.com/dshort/updates/Monthly-Moving-Averages.php
http://www.advisorperspectives.com/dshort/commentaries/Ivy-Portfolio-Review.php
http://www.advisorperspectives.com/dshort/guest/BP-140217-Ivy-Portfolio.php
Put the assets you own into a Globe Watch list – one of the things it easily displays is where the price of your asset is in relation to the 200 day moving average – so it is very easy to see what is a buy and what is a sell.
Just check it once per month and you are all set.
http://www.theglobeandmail.com/globe-investor/my-watchlist/
Great post again… I suppose you are always talking about funds in a RRSP or so. I wonder if it holds true for bonds in taxable accounts…
Your article made mw think of another great recent article, published by the American Association of Individual Investors:
http://www.aaii.com/journal/article/increasing-retirement-withdrawal-rates-through-asset-allocation?adv=yes
…I wonder how you analyse this article and the following exerpt: “These results further emphasize that when market valuations are high and stocks are exposed to an increased probability of low returns, the volatility of (longer-term) bonds can be a “liability” in mitigating sequence-of-return risk; however, in situations where stocks are already favorably valued, and the downside risk to equities is more limited, the volatility of bonds is less problematic.”
…Right now, wouldn’t you consider that the market has a high valuation? If so, how do you reconcile your views and the one in this article?
Thank you for your advice, I really appreciate your posts!
Thanks for this post.
I think a lot of people don’t realize that a zero correlation does not really have diversification value. It’s merely dead weight. It’s a dilution factor so it’s certainly better than positive correlation, but you need negative correlation to achieve diversification. Long-term government bonds do appear to be negatively correlated to stocks during crises (I’ve seen coefficients averaging -0.3 to -0.4 in the U.S when comparing the SPY and 20-year Treasuries).
When the Fed raises rates, Treasury prices will go down. So there are 3 scenarios.
1. Stocks go up (negative correlation)
2. Stocks go down slightly (positive correlation but transient)
3. Stocks plummet, in response to which Treasury prices will go up again (negative correlation, again)
@AM: “A zero correlation does not really have diversification value.” I think we need to make sure we’re clear about what you mean here. Portfolio theory holds that any two assets that are not perfectly correlated will help lower the volatility of a portfolio without sacrificing expected return.
In a crisis, when stocks plummet sharply, then yes, the largest benefit comes from an asset class that goes up. But you also get a significant diversification benefit from an asset class that falls by much less. If your Canadian stocks go down 20% and your foreign stocks fall only 10%, then you’ve still achieved a diversification benefit without negative correlation.
The problem with negative correlation is that it’s elusive. Correlation is backward-looking; it changes over time and can’t be reliably predicted in advance. The relationship between government bonds and stocks is probably the best hope we have for some negative correlation (or at least very low correlation). Long-term bonds will rise in value more when rates fall, but if you want to go that route you need to accept that your bonds will be very volatile. In my experience, very few investors are comfortable with volatility in fixed income.
William Bernstein looks at correlation in his review of The Permanent Portfolio.
http://www.efficientfrontier.com/ef/0adhoc/harry.htm
A problem with negative correlation is that it makes it very hard to hold the dropping asset (Gold in this case) when stocks are doing well.
The asset with the negative correlation will be going down.
As Bernstein points out – The Permanent Portfolio is a great diversifier, but most people can’t handle the negative correlation, because at least one asset class will be a drag on the portfolio at any given time.
This is, of course, ironic, because that is the point of diversification – assets move in different directions. But people don’t like holding the asset that is dropping – or in fact buying more of it as it drops to rebalance the portfolio.
The Permanent Portfolio is what you are looking for – but be careful what you wish for.
Applying the 200 day moving average as a buy/sell signal, to the assets in this portfolio could be of assistance here as well.
Recency bias is huge in the bond bears’ mindset. Before I discovered CCP, I had my bonds stored in the TD Canada Trust Real Return Bond Fund. During the financial crisis, the value of that fund went up 16% one year, and I think maybe 13% the next? They got rebalanced twice into equities when they those were at their lowest. (Thank you, rockstar bonds!!) So, think I’ll keep mine, thanks.
Hi Dan, I recall that you’ve written in other posts that in your consulting practice, you generally have clients use short-term (1-5 year) bonds as the fixed asset portion of their portfolio. However, the model portfolio suggests using Vanguard VAB, which is in the 8 year average bond duration range. What’s your current thinking on which to use in the bond portion of a portfolio? Thanks!
@Tim: It depends entirely on the individual. Most of our clients do use short-term bonds and GICs for their fixed income, but this is not because we’re predicting a rise in interest rates. It’s because many have shorter time horizons and prefer less volatility. For accumulators with a long time horizon I think a broad-based bond fund (like VAB) is usually more appropriate, as long as you comfortable with the added volatility.
Hi newbie investor here. I’ve been seeing my investments go down due to recent bond market issues. Is it best to re-balance portfolios to reduce % of Canadian bond in the investment mix?
I have some investments in the Tangerine Balanced Portfolio and some in the TD eSeries Couch potato Balanced Portfolio.
I’m not in this for the short run of course so I know there’s highs and lows and sometimes you just have to ride it out.
@Alexis: Thanks for the comment. If you are rebalancing now, it would be by buying more bonds to get back to your target asset mix, not selling them to reduce that target number. Remember, the whole point of rebalancing is to sell what has gone up and/or buy what has gone down. The good news is that your Tangerine fund will do that for you automatically, so you don;t need to make any difficult decisions.
@ccp
A lot of talk on BNN last few days of the bond market tanking. I’m still not 100% sure to believe this however. if I get a 10 year bond today paying 2% will I not get the 2% each and every year and at the end of 10 year won’t I still have the whole principal left and will have gotton 2% each year? IF so how can I lose money when bond yields rise which all the experts are talking about? The only way i can see losing money is if I buy a bond that pays a negative yeild.
Lately as we all have noticed the bond funds have lost 2% or more but if i hold the fund from when I purchased it till the avg maturity like 8 years for example I should have not lost a cent and more than likely made money.
@Jake: It’s important to understand that people who give investment advice on BNN think that “the long term” is six to 12 months. You’ve basically got it: bond prices will fall any time interest rates go up, but if you hold an individual bond to maturity you will not lose money. With a bond fund, it’s much less predictable because a bond fund never matures. But as you say, if you hold the fund for a period equal to its duration, your principal is not in jeopardy. That doesn’t mean you’ll never suffer long periods with negative returns: that has happened before and could happen again. But the risks of bonds should be kept in perspective. These may help:
https://canadiancouchpotato.com/2011/07/07/holding-your-bond-fund-for-the-duration/
https://canadiancouchpotato.com/2013/06/10/whats-happening-to-my-bond-etf/
https://canadiancouchpotato.com/2013/09/16/ask-the-spud-should-i-fear-rising-interest-rates/
@ccp
thanks for the reply and links especially the first link posted.
For us investors to hear the doom and gloom of the bond market that the “experts” talk about it is very nerve racking for me. to hear that the bond market is going to tank, equities are overpriced ti makes you wonder what to do with our hard earned money other than savings and gic accounts.
@Jake: That’s the idea: the good people on BNN want to you to pay them to guess about interest rates and equity returns. Note the dates on the blog posts I linked. The gurus have been singing this song for five years. Sooner or later they will be right, but woe to the investor who say in cash for those five years. The best thing you can do for your portfolio is turn off the TV.
“The best thing you can do for your portfolio is turn off the TV.”
Haha. Love it. Those gurus on BNN are the monetary equivalent of the Sunday NFL prognosticators. Check out the season totals of the ‘expert’ predictions.
My understanding is that it is best to keep your fixed income in government bonds as the corporate bond premium is in part an equity premium meaning subject to same swings as the equity markets. See Larry Swedroe’s article entitled “Credit Risk Isn’t Worth It” for a full explanation.
http://www.etf.com/sections/index-investor-corner/swedroe-credit-risk-worth-it?nopaging=1
If you accept that government bonds are the best diversifier and have the best fixed income return/return ratio, wouldn’t it be better to have a laddered portfolio of CDIC guaranteed GIC’s? You can have $100,000 per financial institution, if they are less than five years. If you want to go longer than 5 years, you could go with a BC Credit Union as all amounts and maturities have deposit insurance.
When I compare Vanguard Short Term bond fund (VSB) to holding a 3 year laddered portfolio of GIC’s, I get an uplift of 85 basis points. It is even better after tax because VSB hold a lot of premium bonds. You would do even better, if you matched the maturity of VSB with a laddered portfolio 5 year GIC’s.
In summary, it seems that government bonds are better than corporate bonds as a diversifier, have better reward/risk ratios and the CDIC guaranteed GIC’s are as secure as government bonds but offer much better yields.
@Bill: It’s true that government bonds are likely to be the best diversifier during periods of stock market turmoil. The “flight to safety” is not usually made to corporate bonds.
GICs are an excellent choice for fixed income, but there are some tradeoffs to consider:
https://canadiancouchpotato.com/2015/03/27/ask-the-spud-gics-vs-bond-funds/
Thank you for the reference to your article on GIC vs. Bonds.
One item that is not quite accurate in the above reference article is that GIC maturities greater than 5 years (in unlimited amounts ) are available, if you buy any BC Credit Union GIC’s such as Van City. They are guaranteed via BC legislation. Interest and foreign currency are also guaranteed. Below is the reference.
http://www.cudicbc.ca/
Also, I am not sure I agree with your statement In the “Bond vs GIC” article that, if interest rates fall, a GIC would see no price appreciation. This is technically correct, but is the result the difference between historical cost and fair market value as there is no secondary market for GIC’s. Since there is no secondary market, your broker statement shows historical cost as the value. However; if we mark-to-market, the fair market value of the GIC has risen, just like a bond when interest rates fall. If you hold the GIC to maturity, your portfolio return will be better than a federal government bond fund of an equivalent duration.
One advantage of a GIC that you did not mention is that you don’t pay a MER. When comparing the yield of a GIC to a bond fund, you should deduct the MER from the yield-to-maturity number provided by the bond fund.
@Bill: If you want to avoid corporate bonds another option is to use a 1-10 government bond ETF, such as CLG, thus balancing term risk and reinvestment risk. This what Larry Swedroe does with his clients. Apart from being easier to manage than GIC ladders, you have money available, along with a bump up in price of bonds that occurs with a “flight to safety”, to buy equities at depressed prices.
@Tristan: One thing to be aware of is that CLG (and all of the laddered bond ETFs from iShares) are extremely tax-inefficient, as they have very high coupons compared with their yield to maturity. These should only be used in an RRSP or TFSA.
https://canadiancouchpotato.com/2013/03/06/why-gics-beat-bond-etfs-in-taxable-accounts/
@CCP: Yes, an important point I should have referenced in my comment.